This is the second of two pieces covering the “Advanced Financial Planning — Real World Strategies” panel Tuesday morning at Exchange in Miami, hosted by Vance Barse, wealth strategist and founder of Your Dedicated Fiduciary. Click here for part one.
Estate Freezing Techniques for High Net Worth Clients
Advisors may also want to better familiarize themselves with estate freezing techniques. The two goals of freezing techniques, Barse said, are to get appreciation out of the grantor’s estate and to transfer property at a reduced value.
The three ways to do that are an intentionally defective grantor trust (IDGT), a grantor-retained interest trust, and a qualified personal residence trust.
The first, the IDGT, is designed to facilitate an income tax-free sale of a business or property with appreciation potential to a trust whose beneficiaries are heirs of the grantor. It’s an irrevocable trust that removes assets from the state tax but not away from the income tax, with potential appreciation of property in the IDGT removed from the grantor’s estate.
“Why would Cheryl want to pay income taxes in this case? Because paying the tax will help reduce the overall taxable estate,” Barse said.
Assets can either be sold to the trust through installment sale or be gifted, but a key factor is that if prepared accordingly, the sale to the trust by the grantor avoids cap gains taxes, and the note interest received by the grantor has no income tax. The gift value can be discounted, as well.
So if Cheryl sells a $20 million business and seeds $2 million for the trust, she first receives $400,000 in interest, and she does pay taxes on the trust itself. The benefit, though, is that growth on the $20 million avoids the estate tax.
The grantor-retained interest trust is specifically created for the grantor with a qualified interest to transfer property but maintain the right to receive income from that property for a term of years. A qualified interest must be satisfied according to IRC Section § 2702, Barse said, because if retained interest is not qualified, it’s deemed a gift.
Grantor Trust Flavors
The two flavors of a grantor trust are the grantor-retained annuity trust (GRAT) where the grantor gets a fixed annuity, and the grantor-retained unitrust (GRUT) where the grantor receives an annual percentage. The latter may appeal more, Barse said, in inflationary periods.
Those trusts help save on gift taxes because the present value of the grantor’s retained interest reduces the value of the gift. When the trust terminates, the property passes to remaining beneficiaries, with appreciation occurring outside the grantor estate.
“For GRATS and GRUTS to be effective to accomplish tax savings, the grantor must survive the term of the rust. We don’t want to do a GRAT or a GRUT for a 92-year-old grandparent with medical issues who has to survive the next six months,” Barse said.
Personal Residence Trusts
The qualified personal residence trust, or QPRT, is an irrevocable trust that gives the grantor’s house away, but allows the grantor to keep possession for a specified term, at the end of which the house is passed to the heirs and the grantor must pay market rent.
The grantor is enabled to define the length of the QPRT, and at the end of the term, the residence is removed from the grantor’s estate, with the grantor required to outlive the term.
The home sale capital gain exclusion is retained if the home is sold during the term, however. It also doesn’t qualify for an annual gift tax exclusion, with the gift tax assessed on a reduced valuation using IRS tables and rates.
So, a 20-year QPRT comes with less of a gift than a 10-year QPRT, and so as long as the grantor outlives the term, the value of the home plus any appreciation completely avoids the estate tax.
There are two goals to multigenerational planning, Barse said. One is to tax-efficiently transfer assets, and the other is to keep as much of the estate within the family as possible.
“Oftentimes behind closed doors, clients say their biggest fear isn’t that it’s going to be taxed, it’s that their fortune is going to be the source of disunion for their heirs,” Barse said.
The strategies to consider are a dynasty trust, a GST, a Family Limited Partnership (FLP), or a Family Limited Liability Company.
The dynasty trust is a long-term irrevocable trust established specifically to facilitate wealth transfer from generation to generation without estate, gift, or generation-skipping taxes for the duration that the property remains in the trust. Estate, gift, and generation-skipping taxes may be triggered when the trust is established if assets exceed federal exemptions.
The grantor appoints a trustee and afterwards has zero control and cannot change the trust terms. The trustee makes distributions to the trust to the beneficiaries per trust terms, and income tax does still apply to beneficiaries of the trust, and thus, assets that don’t produce taxable income like municipal bonds, land, or non-dividend paying stocks are transferred out.
Cheryl and Gus may not make sense for a dynasty trust, Barse said, because they don’t have grandchildren and the other aforementioned strategies meet their needs.
The generation-skipping trust (GST) is an irrevocable trust that specifically bypasses the grantor’s children, generation two or G2, to bequeath assets directly to the grandchildren, G3.
Passing G2, Barse said, eliminates the potential for double estate taxation on assets that would pass first from G1 to G2, and then again from G2 to G3, essentially skipping a round of estate tax. Beneficiaries can be G3 or anyone 37.5 years or more younger than the grantor who is not a spouse or an ex. A GST is not portable between spouses, however.
Family Trust and Family Business Structures
Two additional strategies are family limited partnerships (FLP) and the family limited liability company (FLLC), which can facilitate the transfer of a business to the next generation and help protect assets from potential creditors, while minimizing income, gift, and estate taxes. Ownership in family business trust structures is split into general partners and limited partners.
In a FLP, general partners (the parents) manage the business while limited partners (the children) have no authority to direct business operations but are protected from liability. With FLP, general partners gift limited partnership interests to the younger generation and can gift up to 99% of the business. With an FLLC, all family members have limited liability.
A statutory protection protects members from claims against LLC assets in an FLLC, while “charging orders” protect LLC assets from claims against members, adding to the benefits of the structure.
Work With the CPA on Charitable Giving
Finally, advisors should consider charitable giving, Barse said. The charitable tax deduction is based on fair market value, Barse said, unless the asset has short-term appreciation. Charitable deductions to public charities are limited to 60% of AGI for gifts of cash and 30% for long-term appreciate assets, while private foundation deductions are limited to 30% of AGI for gifts of cash or 20% for long-term appreciated assets.
“It’s very important that we lean on the CPA not to be a reactive fax filer and to really emphasize that we do strategic tax planning. Everyone thinks that tax season is April. No! Tax season should be October 15 to December 31,” Barse said.
So what are some charitable giving vehicles? Family foundations are one option, but very few clients actually meet family foundations despite how many clients come to advisors looking for them. They’re best suited for families with real high-dollar money problems, Barse said.
The next to consider would be the donor-advised fund (DAF), or a sponsoring charity, a charity set up for the family who can gift cash or long-term appreciated assets or other things into the DAF and get an immediate deduction. There is no requirement for DAFs that the money be spent out, which allows for long-term investing upside potential.
Qualified charitable distributions, meanwhile, can be very helpful for planning around tax backets, while split-interest gifts like charitable remainder trusts (CRT) hold assets that are not subject to capital gains. The charitable lead trust (CLT) and charitable gift annuity (CGA) are two additional options to consider for charitable giving vehicles.
Coming back to the Cheryl and Gus high net worth clients case study and their desire to sell their company, Barse pointed to the CRT, which pays income and interest to the grantor, with the remainder interest going to an approved charity, which can meet the couple’s desire for a legacy and gives them a tax deduction that year.